Mutual funds need performance-based fees

Commentary: Shareholders should get what they pay for

BOSTON (MarketWatch) -- Mutual funds should make money when you make money.

Alas, the industry isn't really set up that way, according to two studies which show that as the market was bottoming out in 2009, funds were topping off their expenses.

The average fund investor paid an expense ratio of 0.887% in 2009, up from 0.874 a year earlier -- the biggest increase since 2000, according to investment researcher Morningstar Inc. Separately, the Investment Company Institute -- the trade association for the fund industry -- prefers to focus on the idea that expense ratios, overall, have been trending downward for decades, rather than the fact that numbers went up in 2009.

Investors can look at the increase and say it amounts to about a buck of extra costs per $1,000 in a fund, which hardly seems like a backbreaker. But this is a case where the principle may be more important than the actual dollars involved, because it highlights the disconnect between costs and performance.

Official 2009 expense ratios are built on a fiscal year, starting Nov. 1, 2008 and running through Halloween of 2009. That means the costs were measured from the heart of the meltdown through the bottom in March, before the market changed direction.

Broken breakpoints

The average expense ratio was up across the board; every category except for taxable bond funds saw a cost hike in 2009, with the biggest jumps coming in balanced funds and in "alternative" funds (including market-neutral, long-short, commodities funds)

It's not necessarily a surprise that while the market was tanking, costs were going up. Most funds have "breakpoints," where management fees are reduced automatically as assets cross certain levels. Thus, a fund might charge 1% when assets are below $100 million, but cut costs to 0.95% if assets stand between $100 million and $500 million, at which point costs could drop to, say, 0.9% up to $1 billion, and so on.

Breakpoints, however, work in both directions, so that as funds lost a fortune during the market meltdown, assets shriveled, and funds passed those mile-markers going in the wrong direction. Thus, costs went up while the funds were going down in flames.

Now that those fires have been extinguished, the trend should be reversed. A year from now, when numbers are out for 2010, you can bet that expense ratios will have dropped again, probably right back to where they were a year ago.

This is also where the problem is. Intuitively, investors know that fund management deserves more when performance is good, and deserves less when the fund is in the tank. Yet, thanks to the way funds are structured, it worked precisely opposite.

Less than 15% of all funds have performance-based fees, which try to link at least some of management's compensation to results relative to a benchmark. Those funds could have lost money in 2008 but increased costs -- by beating the relevant index, even if just by losing less -- but at least they would have provided something in exchange for the fee increase.

Russel Kinnel, director of mutual fund research at Morningstar, noted that there is a secondary disconnect between what investors got and what they paid.

"In 2008 and early 2009, you had a lot of layoffs, where fund companies were protecting their bottom line, laying off analysts, managers and support," Kinnel said. "If they are cutting costs, so that it now costs less to manage the fund, why weren't they sharing those savings with investors? Yes, a few funds cut fees, but more could have been responsive."

Healthy incentives

Performance fees don't just align investor and fund interests, they keep the manager's incentives in focus too. Many fund companies give managers bonus pay based on results; with a performance-based fee structure, the shareholder and that manager are aligned. If the manager does better, the shareholder should expect to pay him a bit more for success, and if the manager fails, his pay suffers and the shareholder's costs come down.

Further, fund firms had the ability to hold the line on costs despite the breakpoint structure, by simply waiving the increase until performance deserved it. Management companies waive costs all the time, when it is in their best interest; thus, a new fund might reduce costs so that its expense ratio is not onerous, or a bond- or money-market fund will eat some costs so that performance tops the charts and helps to attract more assets.

"Funds definitely could do more to keep costs in line with investor interests," said Kinnel, "but I think they would rather look at the numbers and say 'The long-term trend in expenses is down. Isn't that good enough?'"

It isn't "good enough," because it kicked investors while they were down. But don't expect the industry to change things any time soon.

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